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Longshots, overconfidence and efficiency on the Iowa Electronic Market

Joyce E. Berg and Thomas A. Rietz

International Journal of Forecasting, 2019, vol. 35, issue 1, 271-287

Abstract: We study the forecast accuracy and efficiency of popular “binary” prediction markets. Such markets forecast probabilities for future states of the world (e.g., election winners) by paying off $0 or $1 depending on the realized state (e.g., who actually wins). To assess accuracy, forecast probabilities must be compared to realization frequencies, not individual realizations. We use Iowa Electronic Market (IEM) data to test efficiency against two alternative propositions from behavioral finance: the longshot bias and the overconfidence bias (which yield opposing predictions). No longshot bias appears in IEM markets. Nor does overconfidence influence prices at short horizons. However, overconfident traders may bias prices at intermediate horizons. While the markets are efficient at short horizons, non-market data indicate some intermediate-horizon inefficiency. We calculate Sharpe ratios for static trading strategies and document returns for dynamic trading strategies to assess the economic content of the inefficiencies.

Keywords: Prediction markets; Market efficiency; Longshot bias; Overconfidence (search for similar items in EconPapers)
Date: 2019
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Handle: RePEc:eee:intfor:v:35:y:2019:i:1:p:271-287